Hedge Fund Option Usage and Skewness Risk Premium

Abstract

We study how hedge fund (HF) option usage can affect skewness risk premium in the cross-section of individual stock options. We find that stocks with HFs employing long naked put strategy (long put option without the underlying stock) more heavily have higher returns of their skewness assets comprised of options, whose payoff (price) resembles the realized (risk-neutral) skewness of the underlying stock return. We document evidence consistent with a price-pressure channel: HF demand on put options, especially the out-of-the-money ones, makes those stocks' puts more expensive and their risk-neutral skewness more negative, leading to lower prices of skewness assets. After decomposing risk-neutral skewness into systematic and idiosyncratic components, we find that only idiosyncratic skewness is negatively affected, suggesting that idiosyncratic skewness is priced; HF naked put positions cannot predict realized skewness, indicating a lack of skill in timing crash risk at the individual stock level. Other HF option strategies do not affect skewness risk premium for various reasons.

Keywords: Skewness risk premium, option, hedge fund

JEL Classification: G12, G14, G23